A Spending-Friendly Guide To Building Wealth.
We’ve all heard the phrase you’ve got to spend money to make money. So, does that mean you should hit up the mall and max out those credit cards? Not exactly. But, a little bit of debt can play a big role in securing your financial future – if you use it correctly.
Using simple examples and straightforward explanations, this post presents a comprehensive guide to personal finance that doesn’t treat debt like a four-letter word. They spell out all you need to know about daunting financial concepts such as liquidity, debt-to-asset ratios, and fixed-rate interest rates. Along the way, you’ll pick up realistic strategies for actually attaining your financial goals and learn the right way to leverage debt in your favor.
Debt can be valuable – if it’s managed wisely.
Imagine two families, the Nadas and the Radicals. In many ways, these clans are very similar. They have the same income, they invest in the same mutual funds. They even buy identical adorable row houses side by side. However, there’s one crucial difference: how they approach debt.
The Nadas are traditional. When they took out a home loan, they paid it all back as fast as possible. The Radicals took a different approach. They were fine with having debt. Instead of trying to eliminate it, they just paid the interest each month and invested the difference.
Now, when it comes time to retire, which family has a bigger stack of cash? Did you guess the Radicals? Despite conventional wisdom, they kept their debt and still managed to come out with more money. Maybe debt isn’t so bad after all.
When it comes to personal finance, debt is often vilified as an absolute negative. It’s common sense to avoid it if possible and pay it off quickly if you can’t. A recent survey of college students even found that a whopping 96 percent would prefer to have no debt at all. Yet, if debt is so bad, why do Fortune 500 companies regularly carry debts even when they have plenty of cash?
The truth is, for many companies, debt is a useful tool. Taking it on provides a financial cushion during emergencies or extra cash for when big opportunities arrive. So, what can debt do for you? Well, it can help you buy the things you absolutely need while freeing up your income for other uses, like savings.
Let’s take another look at our two families. To buy their homes, both took out loans of $300,000 with an interest rate of 3 percent. To pay this back quickly, each month the Nadas directed all their extra income, about $2,500, to paying the debt. In contrast, the Radicals only paid the interest, about $750 a month. They put the rest of their cash into savings and investments, with a modest yield of 6 percent.
Essentially, the Radicals kept their debt as a means to start saving early. This gave their money more time to compound over time. When retirement came, their nest egg had seriously grown. Meanwhile, the Nadas paid off their debt and got a later start on investing. Their savings didn’t have time to grow, and they ended up with a much smaller sum.
Avoid bad debt, stockpile cash, and make smart investments.
If we imagine the world of finance as a vast ocean, then you’d be the captain of a ship sailing its seas. As captain, you’d want to chart a course toward a little island called financial security. But, do you know how to get there?
Maybe, maybe not. There are many routes, and no exact map is perfect for everyone. Still, your journey will be simpler with a little help. You need a compass to keep you heading in the right direction and a lighthouse to warn you away from rocky shoals.
Luckily, there are some loose guidelines to help you on your financial voyage. Keep them in mind, and there’ll be smooth sailing ahead.
When mapping your financial future, a few bits of advice can help show you the way. To start, not all debt is equal – some forms are enriching, but others are oppressive. Payday loans and credit card costs are good examples of oppressive debts. These usually have high interest rates and aren’t tax-deductible. Avoid them if you can! In contrast, enriching debts are tax-deductible and have low interest rates. These include mortgages and small business loans, which can be kept to maximize liquidity.
So, what’s liquidity? Basically, it’s cash you can spend right away. This form of wealth is valuable because it increases your financial flexibility. Sometimes in life, you’ll hit choppy waters. You’ll lose a job or have a medical scare. In these cases, having a stockpile of cash will help you weather the storm. For instance, if you need to look for a job, it can help keep you afloat while you search. So, keeping some money that’s always available should be a priority.
In addition to stashing cash, you should also invest for the long term. Make regular deposits into stable savings accounts, 401(k) plans, and mutual funds. These financial instruments offer modest compounding interest rates, meaning the more you put into them early, the faster they grow over time. Saving $15,000 a year at a 6 percent interest rate will result in almost $4 million after 30 years. That’s a hefty sum!
Of course, everyone’s situation is different so the exact distribution of your money will vary from person to person. In general, aim to save about 15 to 20 percent of your income. Sure, you could save more, but it’s also nice to spend some on yourself. After all, if life’s a voyage, shouldn’t it be a pleasure cruise?
Launch your financial LIFE with targeted saving.
Pop into the arcade and play a classic video game. Frogger, Tetris, Pac-Man, it doesn’t matter which one you choose. When you put a quarter in the machine, they all start the same way: at level one. Then, slowly but surely, you build your way up.
A balanced financial journey works the same way. There are four different levels or phases, and each one must be completed in order to move on to the next. You can call these phases your financial LIFE. Phase one is Launch, phase two is Independence, phase three is Freedom, and phase four is Equilibrium.
So, how do you complete each phase? Just like a video game, you level up by maxing out the right stats.
To find out which phase you’re in right now, look at your net worth. Calculate this by adding up all your assets – things like your cash, savings, and real estate – and subtracting all your debts – your mortgages, loans, and tax obligations. If your net worth is less than half your annual income, you’re in the Launch phase. If your net worth is closer to twice your income, congratulations! You’re already in phase two, Independence.
We’ll examine the final two phases later. But for now, let’s talk about moving from Launch to Independence. To do this, you need to hit a few milestones. First, eliminate your oppressive debt by paying outstanding credit card balances. Then, start building liquidity by saving cash. Your goal is a checking account with about one month’s worth of income. Finally, start a retirement account also valued at one month’s income.
If these goals seem difficult, adopt a measured approach with a little math. Write out where each of your accounts currently stands. Then, write down your targets and calculate the difference. Now, you don’t have to make up these gaps right away. Instead, adjust your monthly spending just a bit. Aim to hit your targets in three to five years. Then, it’s on to phase two.
At the Independence phase, you’ll follow the same strategy but shift the targets. Now, you’re aiming for three months’ worth of liquidity and a retirement fund valued at six months of income. You should also start a third account for big life changes like having children or buying a house. Stock this with nine months’ income. Again, it may take a few years, but soon enough, you’ll be on to the next phase!
Attain financial freedom by accumulating assets.
Meet Brandon and Teresa, a married couple living in downtown Chicago. For the past decade, they’ve carefully managed their finances. Each month, they save some cash, add to their savings, and put a little away for big life changes. Good job, Brandon and Teresa! Phase one and two of LIFE are complete.
Now, it’s time for phases three and four, Freedom and Equilibrium. Here, the game changes a bit. Rather than focusing on monthly income, these phases examine your overall debt-to-asset ratio, or debt ratio. This ratio is the balance between what you owe and what you own.
So, for Brandon and Teresa, the goal of these final phases is to build wealth and prepare for retirement by maintaining a healthy debt ratio.
By the time you enter phase three, you will already have a strong financial base. In fact, by saving and investing, your net worth should be about five times your annual income. With this stash, you’ll be ready to navigate any financial setbacks. You’re also on the right path for retirement, even if it’s 20 years away.
Now, throughout the Freedom phase, the aim is to accumulate wealth. The best way to accomplish this is by lowering your debt ratio to a healthy level. What’s a healthy level? Well, earlier in life, lower incomes and big home loans usually put people’s ratios at around 65 percent. For a couple like Brandon and Teresa, that means having $300,000 in assets and a $200,000 mortgage. By the end of phase three, this should be closer to 35 or 40 percent.
So, how should they get there? Not by paying off the debt. Instead, the couple should put most of their money toward retirement savings and long-term investments. Due to compound interest, these accounts will grow over time. Assuming modest appreciation, in a few years, the pair could have $500,000 in assets. Even with their original debt, that puts their ratio at a cool 40 percent. Not bad.
As your assets keep growing, this ratio will continue to drop. Eventually, you’ll have enough money that paying off the debt will be a trivial cost. This is the fourth and final phase, called Equilibrium. At this point, having debt is completely optional. Paying it off won’t hinder your savings, but keeping it around isn’t a huge risk, either. For Brandon and Teresa, this means retirement is just around the corner.
To beat debt, a diversified portfolio is a smart investment.
You’re sitting in a dark room. The aroma of incense is thick in the air. Across from you, a mysterious woman stares intently into a crystal ball. The orb hums and glows. Suddenly, she speaks, “US commodity returns will rise by 9 percent!”
If this sounds ridiculous, that’s because it is. No divine oracle or gifted fortune-teller can accurately predict the financial market’s future movements. In fact, anyone who thinks they can is either delusional, or worse, deceitful.
Yet, this doesn’t mean investing is completely up to chance. If you want to reap steady rewards from your portfolio, there are simple strategies that tend to yield better results.
By now, it should be clear that the trick to making debt work is having your investments outperform the cost of the debt. If your debt has a 3 percent interest rate, but your assets have a return of 6 percent, you’ll come out with more value in the end. This is called capturing the spread and, as an investor, this should always be your goal.
So, how do you capture the spread? Some people recommend closely monitoring the financial world and business news in order to pick winning stocks. After all, between 1970 and 2015, the market rose at an average of 10 percent a year — that outperforms most debt. The problem is that this is an average. Individual stocks are more unpredictable. If your picks drop when you need them, you’ll be seriously underwater.
So, a better strategy is to adopt a diversified investment policy. This means spreading your investments across many different asset classes. For example, you’ll want some money in US stocks, some in real estate, some in international bonds, and yet more in other investments. That way, you’re spreading your risk, too. Even if some assets drop, others are likely to rise. Looking at past performance, this approach captures the spread 92 percent of the time.
If you have a little more money to play with, you can diversify even more. A mature investment portfolio has three different pools or categories. A conservative low-yield portfolio, an average core portfolio, and an aggressive portfolio for investments with high risk but high rewards.
No matter your financial strategy, it’s true that the future will always remain uncertain. But, it will probably be a lot brighter when you have a smart plan – even if you have debt.
Common-sense financial advice tells us to avoid debt at all costs and to pay it off as soon as possible. However, not all debts are the same, and if you adopt the right approach, enriching debt, like mortgages, can actually help you build wealth. Don’t just pour all your money into paying off your principle. Instead, invest in assets that yield higher returns than your interest rate. Over time, your money will compound, giving you a comfortable nest egg and enough liquidity to pay off your original loans.
Action plan: Consider renting!
People often think owning a home is the key to financial freedom. While this is often the case, renting can also be a smart decision. When you’re thinking about buying, don’t just look at the mortgage, make sure to consider other costs such as property taxes, maintenance, and possible depreciation. In some cases, renting is the way to go.
